The month of March has been a game of Whac-A-Mole for central banks. One financial market after another springs a leak, gets patched up, and then the process repeats. But even veteran market participants were surprised to see the Federal Reserve rushing to the aid of the municipal market.
On March 20, as yields in the normally staid municipal market soared, the Fed announced it would allow banks access to loans if they used assets purchased from tax-exempt municipal money-market mutual funds.
The yield surge was caused by a massive muni bond sell-off that was, like many of the other market gyrations throughout March, driven by panicked investors tripping over each other as they rushed for the door. And while the Fed’s intervention has helped stabilize the market for now, there’s likely a lot of pain ahead for the state and local bond issuers that make up the $3.85 trillion-muni market.
“It’s in the best interest of the Fed and the national economy to have the muni sector functioning effectively, particularly when the current downturn is driven by a virus that drags in states and localities as providers of health care and public services,” said Christopher Mier, chief strategist and economist for Chicago-based Loop Capital Markets.
Yields in the municipal market touched an all-time low — and prices, therefore, an all-time high — on March 9, said Matt Fabian, a partner with Municipal Market Analytics. But as anxiety over the fast-moving coronavirus pandemic rippled through financial markets, investors tried to sell everything in a mad dash for cash.
For munis, the selling frenzy started with investors trying to liquidate their muni money-market funds, Fabian said. About $11 billion — nearly 10% of the market — sold off in about a week.
Another consideration: over the past year or so, munis have become “almost entirely dependent on fund investors,” Fabian said. Throughout 2019, municipal assets in mutual and exchange-traded funds increased by $156 billion: more than three times as much as all other investor types combined. When investors in those funds started selling to try to raise cash, it forced the asset managers to sell the underlying securities in the funds.
“The market seized up,” said Eric Kazatsky, head of municipal strategy for Bloomberg Intelligence. “It was a perfect storm for munis.” As it’s done in other markets, the Fed’s intervention made it a buyer of last resort for the bonds investors wanted to exchange for cash.
Yields surged by 200 basis points over a matter of days to levels “no-one in the market had ever seen before,” Fabian said. He and others are quick to note that the yield shock was due to the liquidity issue, not underlying fundamentals in the marketplace, and that yields have retrenched about 150 basis points of that March spike. One of the largest exchange-traded funds that tracks munis, the iShares National Muni Bond fund /zigman2/quotes/208028380/composite MUB +0.03% , is roughly flat for the year to date, according to FactSet.
As Kazatsky put it, what the Fed didn’t want is “states and locals borrowing at high rates at a time went they’re expecting both expense shocks and revenue shocks.”
Those shocks are all about the coronavirus pandemic. Health care systems and policies are state-driven, and the emergency personnel on the front lines are paid by cities and towns. States will have to make do with lower revenues from income and sales taxes at the same time as unemployment benefit payouts are soaring. A good portion of the budgets of all states and locals aren’t discretionary, but fixed, for things like pension costs.
But it’s important to note that bonds issued by states and localities are only part of the muni market. About two-thirds of the market is “revenue” bonds — those issued by everything from hospitals to transportation providers to colleges and universities, all of which are about to take a serious hit from a shuddering economy.
“You could draw a dotted line from the economic impact of coronavirus to any facet of muni finance,” Kazatsky said.
“Investors have to brace for systemic downgrades across states, cities, hospitals, transportation, even essential service utilities,” Fabian said. “You can think some pretty grim things these days. The economic data is going to turn terrible.”
What does that mean? The municipal market is wary of sweeping predictions, like the one in 2010 by banking analyst Meredith Whitney, who warned of “a spate of municipal bond defaults,” as if state and local governments had never confronted an economic downturn before.
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Still, Fabian thinks this time might just be different.
“We could see things happen that have never happened before,” he said. “Borrowers that people have treated as absolutely safe can’t be treated that way. Even in the worst downturns, states and cities don’t default. But with social distancing and everyone at home, millions unemployed, it’s hard to take anything for granted. There could be temporary violations of bond covenants, technical defaults, reserve fund draws, things you would never expect.”
It’s important to understand, though, that most such hiccups will likely be temporary: problems of budgetary liquidity, not solvency, Fabian stressed. Working in public finance professionals’ favor: most municipal entities have July – June fiscal years, so they’re getting ready to start the budgeting process in the coming weeks. That means they can proactively account for doomsday scenarios for the next year.
And the municipal default rate is a fraction of that of the corporate market to begin with: 0.18% in 2018, compared with 1.74% for corporates, according to the Municipal Securities Rulemaking Board.
Still, this is an unprecedented moment. To take one example, with air traffic down about 90% , airlines and airports are getting billions in federal dollars, Fabian noted. “But what if we have two-three months with zero enplanements? I just don’t know what happens.”